2019 has been a strong year for financial securities, with all asset classes delivering double-digit returns year-to-date. The reason for the strong financial market return is apparent: global central banks, especially the Federal Reserve (Fed), have changed course from monetary tightening to easing mode. At the end of 2018, the U.S. market was expecting one rate hike for 2019. Now, however, the market has priced in three rate cuts for the year, significantly easing financial conditions as a result of this change in expectations.
For the Fed, the rationale for a rate cut is risk management. Even after 10 years of economic expansion and a record low unemployment rate, inflation is still below the 2% Fed target. With global manufacturing Purchasing Managers’ Index (PMI) slowing down and increased uncertainties surrounding U.S.-China trade, the Fed anticipates that a few rate cuts now can sustain the economic expansion and drive up inflation towards the 2% target.
I am doubtful that easier monetary policy can drive up inflation. A tighter labor market leads to higher wages and subsequently, higher inflation results in pricing power. With pricing power, a company can pass the higher labor costs to consumers. Now, very few companies have pricing power, and even if they have pricing power, it is very likely to be eliminated in a few years. Because of this extremely competitive environment, businesses have learned to focus on what they can control: cost. When we look at the market’s pricing for future inflation expectation, the Fed has made a dovish pivot twice this year. Meanwhile, 10-year breakeven inflation is up approximately 10 basis points, still a depressed level. Therefore, the market does not believe that the Fed can engineer higher inflation.
Although I don’t believe easier monetary policy can generate higher inflation, I cannot deny its impact on asset prices. Over the last 10 years, investors have been trained to press the “buy” button once the Fed hints lower rates or more quantitative easing. The wealth effect sustains the economic expansion. When we look at the chart of the week, global yield is currently at historical lows. How much more monetary stimulus can we engineer?
Among all major central banks, the Fed has the most room to ease. President Trump has made it clear that he prefers a weaker dollar. The dollar is likely to weaken once the Fed implements a rate cut in the U.S. Because of this view, I have been keeping a close eye on precious metals and emerging market local currency debt. These two asset classes will not only benefit from a weaker dollar, but their valuation is also inexpensive. Both asset classes have done well in the past month amid rate cut expectations.
The Fed has much more room to ease compared to other central banks. This is a headwind for the dollar. Precious metals and emerging market local currency debt may fare well once the easing cycle commences.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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